April 15 is still a ways off and taxes are probably pretty far from your mind. Now, however, is a great time to take advantage of tax-saving opportunities that will be lost once the year is over.
The following are some often overlooked tax-planning areas to consider while there is still time to act and pay less in taxes in this tax year and beyond.
1. Contribute to a Roth
Most folks know that saving in a workplace retirement plan such as a 401k is a great way to shield income from taxes while building up a nest egg for retirement.
Many of us forget, however, that these pre-tax savings will someday be taxed as income when we begin making withdrawals in retirement. Ideally, the rates at which these withdrawals are taxed will be lower than the tax bracket we were in when making contributions. This is the ideal arbitrage scenario and is often true for mid-career and senior employees.
Younger workers just starting the climb up the career ladder, however, are typically in a lower tax bracket than they will be later in their careers and in retirement. For these folks, another retirement savings vehicle, the Roth IRA, may be a better option.
While contributions to a Roth are made with after-tax dollars, both these contributions and their earnings can be withdrawn free of income tax in the future. Younger workers can come out ahead by investing in a Roth with after-tax money when in a lower tax bracket in exchange for not paying income taxes in the future on withdrawals when they have entered a higher tax bracket.
One caveat is that if an employer matches 401k contributions, it is a good idea to save enough to qualify for the match before directing after-tax savings to a Roth. The match is, in effect, a guaranteed return and should not be passed up. Note that while contributions to an employer Roth 401K must be made by 12/31, you actually have until April 15 of the following year to make an individual Roth IRA contribution for the current tax year.
2. Spend Your Flexible Spending Account (FSA) Money
Many employers offer their employees a way to set aside a portion of their salary on a pre-tax basis to pay for out-of-pocket medical expenses and for child and dependent care. Given that the IRS does not allow a deduction for medical expenses that do not exceed 10 percent of adjusted gross income, an FSA is usually the only way to save taxes on these expenses.
FSAs are particularly valuable for taxpayers who are impacted by the AMT tax as a way to lower their taxes via pre-tax savings, thereby offsetting some of the deductions lost due to the AMT.
You need to spend unused savings before year end or risk losing them if your company’s plan is the “use it or lose it” kind. IRS rules allow employers to offer the option of rolling over as much as $500 of unused savings to the following year, but this is not mandatory.
3. Check Your Income and Withholdings to Date
We need to pay taxes throughout the year on our income to avoid a large tax bill and penalties for under withholding. We do this via payroll withholdings and estimated tax payments. The rule for avoiding an underpayment penalty, known as the “safe harbor,” is to withhold 100 percent (110 percent for higher earners) of the tax due in the previous year or 90 percent of the tax due in the current year.
An additional complication is the 0.9 percent Medicare surtax for higher earners. This is due on earned income over $250,000 for married couples ($200,000 for singles). Couples earning more than $250,000 may be at risk of under withholding because employers only begin withholding for this surtax once individual wages reach $200,000. If each spouse earns $200,000, as a couple they will earn $400,000 and will owe additional tax on $150,000, the excess over $250,000.
Since none of the Medicare surtax would have been withheld from their salary, additional estimated taxes are needed to avoid a possible underpayment penalty.
4. Perform a Roth Conversion in a Low Income Year
Despite improvements, our economy is still recovering. While unemployment has fallen, many of us remain out of work and it is taking longer for the unemployed to find a new job. Unemployed workers can experience a significant income decline and drop down one or more tax brackets as a result.
While upsetting and stressful, a significant temporary drop in income opens up the opportunity to convert an IRA to a Roth at a low tax rate and convert taxable income to tax-free income for a relatively low cost. Folks whose income has fallen low enough that their deductions exceed their tax can even perform a partial Roth conversion for no tax at all.
The above are just some of the tax-planning issues often overlooked by taxpayers. A little time spent planning for these before Dec. 31 can help you reap large rewards in the form of tax savings and future growth of wealth.
Speak to a tax professional to review your situation and put the tax code to work for you to help you save money and avoid surprises next April.